The US Federal Reserve's decision to exit from so-called "quantitative easing" - its massive monthly purchases of long-term assets - is stoking fears of a hard economic landing in China. But the country's strong economic fundamentals mean policymakers have the space to avoid such an outcome - as long as they bring the shadow banking system under control.

As it stands, Chinese consumption and investment growth are expected to remain at roughly last year's levels. Meanwhile, economic recovery in the advanced economies, especially the US and Europe, is reinvigorating external demand, leading analysts to project annual Chinese export growth of more than 10 per cent this year. This would bring annual GDP growth this year to a very healthy 7.5-8 per cent.

The problem is that China's financial sector has accumulated considerable risk in recent years, with broad money (M2) having ballooned to 110.7 trillion yuan (HK$140 trillion) - almost twice the country's gross domestic product - at the end of last year. In an attempt to rein in M2, which could indicate that the economy is overleveraged, the central bank tightened conditions for commercial bank lending, so that, for any given increase in M2, less credit is extended.

But the move failed to contain M2 growth. Worse, restricting commercial banks' role as financial intermediaries and encouraging the growth of unregulated shadow banking has generated even more risks for China's economy. Clearly, a new approach is needed - one that is based on a deeper understanding of the dangers inherent in China's banking system.

While it is true that surging M2 can reflect excessive leverage, it is not a particularly accurate gauge in China, where commercial banks can easily circumvent high reserve requirements and quantitative controls by moving loans off their balance sheets to wealth-management products - practices that fuel artificial credit expansion that looks like M2 growth.

In this sense, it is the monetary authorities' reluctance to open up the formal financial sector to domestic private capital, or to liberalise the deposit rate, that is fuelling the expansion of shadow banking.

With small and medium-sized enterprises - by far the economy's most important growth engine - unable to acquire sufficient funding from the formal financial sector, they have been forced to turn to informal channels. As shadow banking has become the primary source of finance for SMEs - which tend to be higher-risk borrowers - the financial risks in China's economy have grown exponentially.

Exacerbating matters, the central bank's repeated efforts to tighten the money supply raises the cost of capital. Last June, the annualised interbank lending rate surged to more than 10 per cent - a level that it almost matched in December. SMEs ultimately shoulder these costs, diminishing their ability to contribute to overall economic growth.

Consider the internet giant Alibaba, which began using Alipay, the Chinese equivalent of PayPal, to raise money last year. In just a few months, it received 400 billion yuan from millions of small investors. Tencent, China's largest internet company, is now using the same strategy to compete with Alibaba, with both companies offering high rates of return - often 6-7 per cent annually - to attract as many investors as possible.

The problem is that most of this investment is in the interbank market, meaning that SMEs ultimately face interest rates of more than 10 per cent - and that does not include the added 3 per cent for SMEs' loan guarantees. These unsustainable high rates are transmitting major risks to the real economy.

Nowhere is this more apparent than in the real-estate sector. Liquidity-thirsty developers, unable to acquire financing through the formal banking sector, have been taking out massive loans at extremely high interest rates. But, in many cases, housing demand has not grown as expected, raising the risk of default - the effects of which would be transmitted to the entire financial sector.

The fact is that China has never been closer to a major financial crisis than it is today. Yet China's monetary authorities do not seem to understand the scale of the risk - or its root causes.

The Chinese economy may well need to be deleveraged. But, instead of blindly tightening the credit supply, policymakers must pursue deep financial-sector reform to liberalise the deposit rate, eliminate quantitative controls and, most important, allow for the establishment of domestic private financial institutions.

Pursuing this agenda is essential to China's long-term financial and economic health. But doing so presupposes a major shift in Chinese monetary authorities' mindset. Therein lies the real challenge facing China today.

Yao Yang is dean of the National School of Development and director of the China Centre for Economic Research at Peking University. Copyright: Project Syndicate

This article appeared in the South China Morning Post print edition as In the dark

Rather than bailing out, the mainland financial authoriies allowed the first ever corporate bond defualt last week. Hope it's a sign that the regulators are really beginning to allow the market to price credit risk properly. That, and other measures as mentioned by the learned professor in his article, will hopefully dissolve the risks of a major meltdown....

Mandmf Mar 11th 20148:46am

Well written!
Totally agree with "instead of blindly tightening the credit supply, policymakers must pursue deep financial-sector reform to liberalise the deposit rate, eliminate quantitative controls and, most important, allow for the establishment of domestic private financial institutions."
You should add removing currency restrictions. SME's are stuck trading in usd. Individuals are limited in their ability to seek alternative global investments due to currency restrictions. Thus everyone chasing after the same pots.